Answer to Question #125449 in Macroeconomics for Ankit

Question

Explain in brief how and why the income and interest sensitivities of the demand for real balances affect the slope of the LM Curve.

Answer 1

The LM curve is a curve that shows the positive relationship between the interest rate and real GDP when there is equilibrium in money market. The LM curve is derived using the money demand and money supply.

Increase in interest sensitivity for real balance reduces the slope of the demand for money curve. The slope is not very steep which indicates that a relatively small decrease in interest rate causes a large increase in the demand for money.

When represented graphically, the money supply is a vertical line, in the short run it is fixed. The graph shows two demand for money curves for different levels on national income. When the demand for money curves and the money supply intersects, this indicate the equilibrium rates of interest.

 Increased demand for real money balances will generate an excess demand for real money balances at the old equilibrium rate. This excess demand for real money balances will induce adjustment in the money market.